Mortgage Interest Tax Deduction is better than I realized?

Tax, SDIRAs & Cost Segregation
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Mortgage Interest Tax Deduction is better than I realized?

Nick Eckemoff
Triangle, NC · Member since 2017 · 28 posts · 6 votes

Sorry if this has been asked before...maybe I'm not using the correct keywords.

I am confused about the mortgage interest tax deduction. I understand that it allows the interest on a mortgage loan to be deducted, but how much considering a mortgage is amortized? The first 5 years or so mortgage payments go mostly to the interest cost. This means that, for at least the first year, 100% of your mortgage payment is interest-only and you can deduct (nearly) the full amount?

For example, on a $120k single family home on a 30 year 4% mortgage, the payment is about $575 per month. This is technically mostly paying the interest for the first years. The sum of the payments is $6900 per year so this would be filed as a deduction? 

I understand that if you file jointly when married the standard deduction is $12,600 in 2017 and might even be doubled pending policy changes. Even still, if you itemize deductions instead of taking the standard deduction, you can exceed this mount pretty quickly considering all the other deductible expenses for a rental property investment. The mortgage deduction alone with two $120k properties would exceed the standard deduction. After a number of years, you can even refinance to reset the amortization and reduce the monthly payment to boost cash flow and continue to maximize on this deduction.

If someone buys a 300k+ house for personal use, the mortgage interest deduction will exceed the standard deduction for the first years.

Am I understanding the mortgage interest deduction correctly?

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Lance LvovskyPro Member
Accountant · Fort Lauderdale, FL · Member since 2013 · 1k+ posts · 753 votes
9y
On a rental property, the mortgage interest is generally fully deductible (unless you do a cash out and use the proceeds for personal use, then interest tracing rules apply). The mortgage interest deductibility for a rental is not limited. On a primary residence, mortgage interest is limited to 1.1 million (1 million of mortgage indebtedness and 100k of home equity indebtedness). Therefore on your Schedule A where you itemize deductions, you are limited to interest up to the first 1.1 million. Up to 2 homes qualify as personal mortgage interest.
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  • Lance LvovskyPro Member
    Accountant · Fort Lauderdale, FL · Member since 2013 · 1k+ posts · 753 votes
    9y
    On a rental property, the mortgage interest is generally fully deductible (unless you do a cash out and use the proceeds for personal use, then interest tracing rules apply). The mortgage interest deductibility for a rental is not limited. On a primary residence, mortgage interest is limited to 1.1 million (1 million of mortgage indebtedness and 100k of home equity indebtedness). Therefore on your Schedule A where you itemize deductions, you are limited to interest up to the first 1.1 million. Up to 2 homes qualify as personal mortgage interest.
    2Reply
  • Nick Eckemoff
    OP
    Triangle, NC · Member since 2017 · 28 posts · 6 votes
    9y

    Thanks for the response. Is the way I calculated the deduction in my example accurate?

    0Reply
  • John Thedford
    Real Estate Broker · Naples, FL · Member since 2013 · 9k+ posts · 6k+ votes
    9y

    Mortgage interest on a personal residence is usually not valuable unless you have a LARGE mortgage.  As the previous poster noted, mortgage interest on an investment is 100% deductible (not the principal payment). 

    0Reply
  • Nick Eckemoff
    OP
    Triangle, NC · Member since 2017 · 28 posts · 6 votes
    9y

    Doing my calculations, the mortgage interest deduction pushes the total deductions higher than the gross rent. This is assuming no rehab or repairs too. Another words, you wouldn't pay any federal taxes on rental property profits.

    A single 120k rental house would mean you'd want to item deductions. If there are additional deductions like an expensive rehab or repair, this could even help me reduce the amount I pay in taxes on the income from my day job. If I had enough investments, I guess this will reduce tax down to zero...but there is an Alternate Minimum Tax (AMT).

    If you do claim the mortgage interest deduction, you HAVE to complete the AMT form then pay whatever taxes are higher (regular or AMT). I don't know much about Alternate Minimum Tax, but reading online, it doesn't allow deductions and is about 25%. 

    Is it possible that claiming mortgage interest deduction and you could end up paying more in taxes via AMT?

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  • Nick Eckemoff
    OP
    Triangle, NC · Member since 2017 · 28 posts · 6 votes
    9y

    I found a good link that explains AMT and how to calculate how much you'd owe.

    https://www.fool.com/taxes/2017/04/15/your-2017-gu...

    Also here is a link to calculate Fed income tax.

    https://www.calcxml.com/calculators/federal-income...

    In summary, if I am doing the calculations correctly, if you make more than $160k (married filing jointly) and claim a single mortgage interest tax deduction, you'd have to pay AMT, which will be far greater than doing a standard deduction. A $160k income would disallow an $84k exemption due to the AMT rules. You could end up paying $30k more via AMT because your effective tax rate will go from 12% to 26% (10% more) because AMT only has 2 tax brackets. However if you make less than $160k or near this amount, you can claim up to $40k of itemized deductions before being subject to paying AMT.

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  • Ashish AcharyaBusiness Member
    CPA, CFP®, PFS · FL · Member since 2017 · 5k+ posts · 3k+ votes
    9y

    There is two criteria if you need to calculate ATM:

    1) If have claimed or received any of the following:

    • Tax-exempt interest from private activity bonds.
    • Intangible drilling, circulation, research, experimental, or mining costs.
    • Amortization of pollution-control facilities or depletion.
    • Income or (loss) from tax-shelter farm activities, passive activities, partnerships, S corporations, or activities for which you aren't at risk.
    • Income from long-term contracts not figured using the percentage-of-completion method.
    • Interest paid on a home mortgage not used to buy, build, or substantially improve your home.
    • Investment interest expense reported on Form 4952. Net operating loss deduction.
    • Alternative minimum tax adjustments from an estate, trust, electing large partnership, cooperative. Section 1202 exclusion.
    • Stock by exercising an incentive stock option and you didn't dispose of the stock in the same year.
    • Any general business credit claimed on Form 3800 if either line 6 (in Part I) or line 25 of Form 3800 is more than zero.
    • Qualified electric vehicle credit.
    • Alternative fuel vehicle refueling property tax.
    • Credit for prior year minimum tax.
    • Foreign tax credit

    If you have claimed or received any, than you have to calculate ATM.

    2) If first criteria does not apply, you still need to figure out if you need to calculate ATM tax. There is a worksheet (in 1040 instruction ) that you can use to figure out if you need to calculate ATM tax (form 6251)

    Worksheet will ask bunch of question that will give you “end “number.

    A) If the end amount on that worksheet is >$186,300 ($93,150 if married filing separately) than you have to fill form 6251 to calculate ATM tax.

    B) If 1 doesn’t apply, you multiple the end result of the worksheet with 26% and if that is greater your tax (in 1040), than you have to have to calculate ATM.

    If your ATM is going to be greater than tax, it depends on your specific situation. Consult with you CPA he will be able to help you. 

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  • Nick Eckemoff
    OP
    Triangle, NC · Member since 2017 · 28 posts · 6 votes
    9y

    The way I read is if you file a mortgage interest deduction claim for a rental house will have to follow AMT.

    • Interest paid on a home mortgage not used to buy, build, or substantially improve your home.
    0Reply
  • Dan Schwartz
    Real Estate Investor · Tempe, AZ · Member since 2012 · 874 posts · 648 votes
    9y
    Mortgage interest for a rental home is deducted on Schedule E. Mortgage interest for a personal residence is deducted on Schedule A. Principal payments are not deductible. These are important concepts.
    0Reply
  • Nick Eckemoff
    OP
    Triangle, NC · Member since 2017 · 28 posts · 6 votes
    9y

    Ran numbers again and found that 40k of itemized deductions (instead of accepting the standard deduction) would save 6-7k on federal taxes at a $150-160k income. This is assuming two $120k houses rent for $1200 each, with about a (mostly interest) $600 mortgage payment each and you have additional personal expenses to deduct. The additional deductions would be only 14k just from the mortgages interest deduction, where 26k is from other expenses. What this means is that you save about 3k from only the mortgage interest deduction. So with this situation, you are saving about 20% on the mortgage payments.

    If can claim 100k of itemized deductions including mortgage interest expenses, there will be no gains because of AMT (or you might even owe more taxes). For example, with 160k income and 100k itemized deductions, you'd pay 5k of federal taxes normally, however under AMT guidelines, you have to pay 15k. This is long as income is under the 160k threshold to allow a 84k exemption...if income passes the threshold, you lose the exemption and have to pay significantly more taxes (flat 26% or 28% instead of the regular tax brackets). 

    The bottom line is the mortgage interest tax deduction can be very beneficial under the right conditions. I'm no tax pro so don't take my advice on this though...there are lots of variables and people have different situations.

    0Reply
  • Nick Eckemoff
    OP
    Triangle, NC · Member since 2017 · 28 posts · 6 votes
    9y

    Reading about Trump's tax plan...

    1) Mortgage interest deduction retained

    2) Doubles standard deduction 

    Home prices will drop and less homes will be sold to people as a primary residence. I don't think the price of rent will be impacted. Great opportunity for investors! Lower prices and less competition...not sure how it is in other areas, but central NC is a seller's market. For buyers, its hard to compete because people are willing to overpay on a house to be used as a primary residence instead of an investment. Maybe the changes will help turn this around.

    0Reply
  • Paul Allen
    Financial Advisor · Virginia Beach, VA · Member since 2017 · 502 posts · 508 votes
    9y

    @Nick Eckemoff you seem to be confusing two separate things:

    The mortgage interest for rental properties is deducted as a business expense on schedule E and does not impact whether or not you would claim the standard deduction or itemize your personal deductions.

    Mortgage interest for your personal residence is claimed on schedule A if you itemize - or you can opt to take the standard deduction.

    0Reply
  • Nick Eckemoff
    OP
    Triangle, NC · Member since 2017 · 28 posts · 6 votes
    9y

    Sorry this is first time digging into taxes associated investing in real estate. All the stuff I posted was under the assumption the property is purchased as a primary house which would be on schedule A, however earned income for real estate investments must be on schedule E as mentioned.

    I read up on schedule E. Essentially what this means is you list all the expenses as deductions and calculate a total income gain or loss that then goes on your 1040, which has your total. If you had a gain, you'd be taxed on that additional income. Due to all the allowed expenses and things like depreciation, I guess most will be reporting an income loss on their properties even though they might have had positive cash flow the whole year. This basically means you will not pay federal tax on passive income from real estate unless the expenses were very low and the rent you collected was really high.

    If you make less than $100-150k and actively participated in the real estate investment, you can actually use up to $25k of losses as a deduction on other income that wasn't passive (day job etc). Real estate professionals don't have this limit because their income isn't considered passive (their day job is real estate), so they can claim many deductions and the loss per property could be used as a deduction on their income.

    In summary you don't really pay federal tax on passive income from real estate investments if you file your taxes right and keep track of all the expenses. The mortgage interest deduction helps with that, but it's possible other deductions on schedule E will net a loss without it (the mortgage interest deduction would just be exta loss that aside from recording every year, wouldn't actually do anything). You will always pay property tax though.

    States tax differently, but I think you are also able to use expenses to offset passive income. Will look into how it works in NC...

    1Reply
  • Itiel Latova
    Hillside, NJ · Member since 2017 · 12 posts · 3 votes
    9y
    Is PMI that is paid on top of the mortgage payment also deductible?
    0Reply
  • Dan Schwartz
    Real Estate Investor · Tempe, AZ · Member since 2012 · 874 posts · 648 votes
    9y
    PMI is deductible if income is below a certain threshold. Check with an accountant or the IRS for your situation.
    0Reply
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